Tuesday, October 30, 2012

Legislation
providing for the orderly resolution of failed financial institutions is an important
practical step towards preventing systemic risk and ending too-big-to-fail, as
well as lowering the societal costs of the failure of a large interconnected
financial firm, noted Andrew Haldane, Executive Director of Stability for the
Bank of England. While it is striking how much progress has been made in so
short a space of time on so complex an issue, he noted, the practical question
is how far this takes us towards removing the too-big-to-fail externality. In
recent remarks, he posited that the faithful implementation of both the letter
and the spirit of the Volcker Rule in the US
and the Vickers Commission ring-fence proposals in the UK will enhance
the ability of resolution authorities to succeed in the goal of ending
too-big-to-fail.

He mentioned that
Title II of the Dodd-Frank Act creates a new regime for the resolution and liquidation
of financial companies, banks and non-banks, which pose a systemic financial stability
risk. It enables losses to be imposed on
creditors in resolution, while also prohibiting state bail-outs. Internationally,
in November 2011 the G20 endorsed the Financial Stability Board’s Key
Attributes of Effective Resolution Regimes, developed by an international
working group. Efforts are underway to align national resolution regimes with
these principles. As part of that, in Europe a draft Directive on recovery and resolution of
financial institutions was published in June 2012.

During the
resolution of a financial firm, noted the Executive Director, one way of
ensuring continuity of services is by transferring assets and/or liabilities of
a failing firm to a third party. But he
noted that the only entity with sufficient financial and managerial resource to
absorb a large asset or liability portfolio, without ``suffering chronic indigestion,’’
is another large financial institution, citing examples during the crisis of Bear
Stearns being swallowed by JP Morgan Chase, Merrill Lynch by Bank of America
and Washington Mutual by Citigroup.

According to the
senior official, this makes for an uncomfortable evolutionary trajectory, with
rising levels of banking concentration and ever-larger too-big-to-fail
banks. Levels of banking concentration
have risen in many countries since 2007, he noted, precisely because of such ``shot-gun
marriages by over-sized partners.’’ In
other words, resolving big banks may have helped yesterday’s too-big-to-fail
problem, but at the expense of worsening tomorrow’s problems.

One way of lessening
that dilemma, he reasoned, and at the same making resolution more credible, is
to act on the scale and structure of financial firms directly. Recent
regulatory reforms have sought to do just that. In the United States, the Volcker Rule
prohibits US-operating banks from undertaking proprietary trading and sponsoring
hedge funds and engaging in other types of private equity activity.

In the United Kingdom,
the proposals of the Vickers Commission include placing a ring-fence around
retail banking activities, supported by higher levels of capital, and thus
fencing them off from commercial banking. The government’s plan is to enact the
ring-fence through legislation. The EU announced the Liikanen plan in October
2012, which proposes that the investment banking activities of universal banks
be placed in a separate entity from the remainder of the banking group.

Volcker, Vickers and
Liikanen seek legal, financial and operational separation of activities, noted
the Executive Director, and thus in principle should prevent
cross-contamination of retail and investment banking at crisis time. Whether they do so in practice, said the
official, depends on loopholes in, or omissions from, the ring-fence.

And each of the
existing proposals has open questions on this front. For example, the Volcker Rule
separates only a fairly limited range of potentially risky investment bank

activities, in the
form of proprietary trading. The Vickers
proposals mandate only a limited range of basic banking activities to lie
within the ring-fence, namely deposit-taking and overdrafts. And the Liikanen plan allows a wide range of
derivative activity to lie outside of the investment banking ring-fence.